Valeri Fadeyev

The powers that be are concerned about falling numbers. If they react hastily, the situation could get worse. The government is being held hostage by misguided goals. With presidential elections coming up in 2004, economic instability is far from desirable. If several fundamental economic problems such as low productivity and investment rates are not addressed, the situation will remain unstable. This means that Putin will change his cabinet. Perhaps as soon as this year…

The Russian economy's main problem is low productivity. Unfortunately, the government can't find the time to deal with it.

The Russian economy is falling. The information went with surprising speed to the top. Signs that economic growth was slowing appeared late last year, and by February everyone was already talking about it. Back in October 1998 immediately after the economic crisis, for example, news of an upswing didn't seem to reach Primakov's government until sometime in the summer of 1999, right at the moment when President Yeltsin had decided to fire Primakov. In general, during the entire decade of the nineties, whenever an economic downturn loomed, the powers that be always seemed to be out of step. As soon as they heard that the economy was worsening and that something needed to be done, the economy was already in the process of stabilizing itself. By that time all the government's energy was in vain. On the contrary-everything was fine but they seemed to think that everything was in crisis and some action had to be taken. Because of this, the current proactive approach is impressive.

At the same time, it would have been even more gratifying if the beginning of this downturn hadn't taken the government by surprise at all. Several analysts have been predicting it.

Many have raised the alarm about increasing inflation. However, inflation isn't the problem at all. The government has already foreseen an increase in prices of 12% for this year. In January, according to the State Statistics Committee, prices rose by 3.1% with was clearly too much in order to anticipate for 12% for the year. An 18% increase in prices for the year is far more likely. This prediction is easily made by analyzing inflation rates from the last few years and for the first few weeks of this year.

The inflation situation has not, therefore, become significantly worse, and today's rates correspond with the general pattern of recent years. Some representatives of the government have unfairly sought to blame the Statistics Committee for miscalculating price growth for January or to blame the overly rapid rise in the price of cabbage as the cause of the increase in the price index. It is important to note that the slight trend toward an increase in the price index and inflation (shown in figure 2) is more likely than not connected to a regular, natural economic downturn, as producers attempt to compensate for falling consumer demand by raising prices.

Don't make a move

Last week, President Putin scolded the government: first of all, for talking so loud about rising inflation. There is no need, please, to stir up inflation expectations. And secondly, for their lack of any concerted action to address the economic slowdown. All and all, the president was optimistic: "It isn't a big disaster or problem," but apparently government officials simply need "to understand some elementary discipline." It really isn't a disaster, but there is the problem and it's serious. Solving it by means of increased government discipline seems unlikely.

Worse would be if the government's economic team decides suddenly to take the president's criticism seriously and suddenly take action to "straighten things out" by crudely messing with the economy's natural development. For example, they could give in to pressure from presidential advisor Illarionov and his weak ruble policies. Create a minor devaluation, and Russian producers will again have a fighting chance against imports. How does this work? The Central Bank increases its purchases of hard currency on the market, thereby increasing the dollar's price vis-à-vis the ruble. Then additional rubles are released into the economy. The issue of inflation immediately rears its head. If the economy is growing, companies have long-term plans and this means they need money. The extra emissions benefit the economy, as the newly printed money turns into investments. That is precisely what happened in 1999-2001. But if the economy is headed into a downturn, as it is now, this means the economy has reach the maximum level of productivity. There is no way it can produce any more goods or services than it is at the moment. Any "extra" money will swiftly lead to rising prices. The current level of inflation, 15-20%, is a bit too high for regular economic development. If inflation only doubles, the consequences could be extremely unpleasant, as Russia's recent history demonstrates. Fortunately, there are a few reasonable people on Putin's economic team, thankfully at the level of deputy minister, whose influence is significant enough to reduce the chances of a weak ruble approach.

How the government views the economic situation

There is yet another obstacle preventing the "immediate straightening out of the situation," and that is the economic ideology of the government itself. The logic goes something like this. The rapid growth of the economy after the 1998 crisis was an economic recovery, and the economy simply cannot maintain that pace of growth. They also claim that the structural reforms are holding the economy back. This means that the current slowdown with growth rates at 3-4% per year is a completely natural phenomenon. In terms of the danger of someone trying to "straighten things out," this is a very helpful theory. If everything is going along as it should, there's no need to change anything.

However, things are not quite that simple. If we make a list of the issues that appear to be important to the government, a strange picture emerges.

Everyone's favorite subject seems to be structural reforms. First of all, why should structural reforms automatically lead to an economic slowdown? This means these changes are harmful. Maybe we should forget them so as not to hold back economic growth. Secondly, what are these serious reforms we're looking at? We are talking about housing and utility reforms, which apparently would cause an increase in prices for utilities and services. The powers that be are scared by this thought and have retreated from these reforms. There has also been talk of reforming some of the major monopolies like Gazprom, MPS, and EES Rossiya. While EES Rossiya seems to be pottering around, Gazprom and MPS have switched bosses and are trying to decrease corruption, but no one is talking about reform. Without a doubt, this is for the best as, in our opinion, the true path for developing Gazprom does not lie in shaking it up or chopping it to pieces.

The other "big thing" at the moment is Russia's entry into the WTO. It appears Russia is in the middle of a major catastrophe. Russia is losing four billion dollars on anti-price gouging proceedings. If we join the WTO, we won't lose that money. If Russia really can fend off all "price gouging," which is highly unlikely due to the extreme complexity of proceedings to protect national markets, then we will gain a little bit more than 1% of our GNP. As a comparison, the growth of the Russian apparel and footwear market is a bit less than four billion. For some reason, the administration and the Duma aren't discussing the problems of this industry as actively as the WTO, even though they involve similar amounts of money. Here's another comparison: Gazprom's new leadership estimated its capital's potential worth at 200 billion dollars. Now Gazprom is worth fourteen billion. Dividing this growth in investment over ten years, say, even year will bring in eighteen billion. And this is only one company, albeit a big one. Why isn't the whole country talking about the problem of Gazprom's capital, when its "price" is four and a half times more expensive than the WTO problem?

What needs to be decided

Does this mean that we are calling for the government to do nothing and not mess with the economy? Of course not. We are not about to stop insisting that important decisions need to be made in economic policy, the kind of decisions which are unfortunately beyond the state's powers.

The Russian economy remains extremely weak. The first economic cycle after a decade of chaos lasted for three years and ended at the end of the last year-the beginning of this year. It is almost certain that after a brief pause the economy will pull out of its fall. Yet what will the potential of the next cycle be? How long will it last? How fast will the economy grow and how much will the average Russian's life improve? The answers to these questions are not very optimistic. There is no reason to believe that the recovery will be strong.

The Russian economy is characterized by its extraordinarily low level of productivity, and this means that the majority of its industries are not capable of competing on the world market. In its current state the country's industries cannot dream of gaining a significant share of foreign markets or even withstand the force of imports.

In the end, productivity indicators are determined at the micro-level by the daily decisions of thousands of enterprises. Economic policy should be aimed at helping them make effective decisions and stimulating their growth. What would such a government policy look like?

Productivity is the relationship of the products of economic activity compared to the resources used. To improve it, we could try first of all to improve the labor force. Skilled and educated employees should be hired, outsourcing should come into common usage, and the Japanese methods of maximizing each employee's output should be applied. In terms of energy, technology which conserves energy should be encouraged. In terms of capital, on one hard, an efficient financial system should be established to make credit widely available, and on the other hand, companies borrowing money should be consistently forced to present business plans and transparent finances.

The productivity of capital can also be improved with the help of the tax system. Despite the great unpopularity of differential tax rates, reducing the tax burden on companies engaged in active investment will automatically lead to growth in the average productivity of capital operating in Russia thanks to an increase in the share of new capital. The problem of low capital productivity, moreover, is directly connected to the problem of Russian companies' low rate of investment. The higher their rate of investment, the higher their value, and the more and more favorable loans they can attract. This also affects the productivity indicators, as a company should not only increase its profits, but also its capital. A recent example of this is Vimm-Bill-Dann which not long ago listed its shares on the NYSE. The 200 million the company received from its listing was more than it had ever made in profits.

Now, let's get back to the Russian government and its role in productivity. Government intervention in the market almost always hampers competition, oppresses leading companies, and gives extra profits to unworthy and inefficient state firms. Government intervention should be seen as a way to create and support natural market competition, and not merely in the narrow context of "de-bureaucratization." This also involves pressures from imports and foreign investment. These pressures should not be allowed to kill off domestic producers of goods and services, but should stimulate competition and form alternative possibilities for attracting investment.

Another extremely important way to improve these numbers is the correct choice of strategic economic areas. It is completely clear that we will never be able to compete on a large scale with the Chinese toys or Korean home appliances. We can forget about these industries. Of course, if some Russian wants to build televisions, let him. But there are other economic areas, more efficient for Russia and different in nature. There are areas of popular demand which, while without a large profit margin, have a high sales rates, which grow as the population's wealth grows, and have a high rate of investment. These are specialty areas ranging from café chains to cutting edge designer clothing to a few frigates for China or India. These specialized industries have higher rates of profit compared to mass production and therefore increase productivity.

Clearly, even a fairly shallow analysis of the problem of Russia's low economic efficiency leads to a logical plan for state policy, in which each point is dedicated to achieving a single goal. Our suggestions are not the only ones out there, but regardless which plan it adopts, the state should have clear goals and clear means to achieve them in any policy.

Where to get the money for modernization

No matter which exact economic policy is chosen, making it a reality will require investments. What is the financial potential of today's economy? It has become common custom to say that Russia has an investment resource deficit. This is just not true.

People usually talk about Russians hiding their money in socks and under mattresses, about the financial resources some Russians keep abroad, and about direct foreign investment. In all cases, the amount of money involved is several billion dollars, in reality a small sum. The question is not being asked properly, and this bespeaks a general lack of comprehension of the nature of capital markets based on credit. If all companies had to develop solely by means of resources taken from profits, the world would never have known capitalism or explosive economic growth. At the company level, everyone understands that the most important resources are always credit and capital. The possibility for borrowing and the level of capital and investment define the future value of the company. Shareholders buying a piece of the company and banks lending it money against future earnings don't exist for nothing. It is practically a financial pyramid scheme, but with carefully calculated risks. The faster the economy grows and the faster value is expected to increase, the greater the risk. Almost all of the economic miracles like Japan and Korea were based on this pyramid of credit. In the nineties, the Americans, while working closely with the South Koreans, suddenly realized that most Korean companies were bankrupt by American standards. However, this condition did not prevent Korea from developing feverishly for thirty years.

Thus, investment is a far cry from the money stuffed into Russian housewives' stockings. It is money that can be printed, attracted to the stock market, or gotten from direct investors.

But as long as Russian officials keep repeating the word "devaluation," Russia shouldn't count on foreign investment flowing in. The strength of the ruble is crucial and of utmost importance, as it demonstrates the health of the Russian economy to the rest of the world. Serious investors would never consider putting money into a country which considers its currency a tool for stabilizing its economy.

And in terms of bringing capital to the Russian market, the above example of Gazprom shows the scale of the problem. It is a matter of hundreds of billions, if not trillions of dollars.

What will happen without a government decision

And so, if these basic economic issues are not addressed-low productivity, low rates of investment, lack of credit-the economy will remain unstable. But there is also an important political factor to take into account here, as presidential elections are coming up in two years. What will be the economic backdrop for campaigning? The slower the economic growth, the lower the wages and higher the unemployment, the higher the chances that other forces unrelated to Putin will gain something from the elections, if not win them altogether. It is highly unlikely that the president and his team want to go campaigning without a more reliable economic policy than they have now. Is the current government capable of suggesting such a policy? At present, the answer is no. This means that a change of government is at hand, and most likely, this year, as in 2003 the elections will loom too close.

There is, of course, one problem. There doesn't seem to be anyone out there who can recommend a new, strong economic strategy for Russia.